Now that Congress has resolved the federal budget for a year or more, it should turn its attention to corporate tax reform. Although many Democrats as well as Republicans talk about reducing the domestic tax rate on corporate profits from 35% to 25%, this is not politically feasible. Instead, Congress should concentrate on the most urgent aspect of tax reform – freeing up almost $2 trillion in foreign profits of U.S. corporations, “locked out” of the U.S. because of perverse U.S. tax rules.

Given the large and growing federal debt, tax reform must be revenue neutral : any reduction in tax revenue from lower corporate rates must be offset by other tax changes increasing tax revenue by the same amount. In specific, dropping the corporate tax rate from 35% to 25% will cost the U.S. Treasury roughly $1.2 trillion over the next 10 years. So to finance this rate reduction, Congress must limit or repeal existing tax preferences of U.S. corporations by roughly $1.2 trillion over 10 years. Can that be done realistically? My emphatic answer is NO.

Politicians have often advocated the closing of small tax “loopholes” such as the special rules for corporate jets and the favorable tax treatment of incentives fees for hedge fund managers. Similarly, academics have called for repeal of tax preferences for specific industries such as credit unions, and specific products such as corporate owned life insurance. However, all these tax “loopholes”, if repealed, would raise less than $100 billion of tax revenues over the next 10 years.

The corporate tax preferences involving large numbers are politically untouchable , and economically may be needed by the fragile American economy. These include tax credits for research and development, lower tax rates for manufacturing located in the U.S., and tax exempt interest on municipal bonds held by corporations. Another big revenue raiser would be limiting the corporate interest deduction on debt, which would also help correct the tax code’s bias toward financing corporate activities through bonds or loans, rather than by selling stocks. But that limit has already been attacked by banks, utilities and private equity funds that are highly leveraged with debt.

Last month, the staff of the Senate Finance Committee circulated a draft bill to eliminate faster deductions (accelerated depreciation) on capital expenditures such as plant and equipment. The draft may be justified on policy grounds since it matches the rate of tax deductions to the actual rate of economic depreciation. Nevertheless, it will be strongly opposed by capital-intensive U.S. businesses. Indeed, Congress has recently gone in the opposite direction — allowing certain firms to deduct immediately the total cost of certain capital expenditures regardless of the length of their useful life.

Instead of being caught in a food fight around general corporate tax reform, Congress should focus on the most counterproductive aspect of the American tax system – its treatment of foreign profits of U.S. corporations. Under current law, these foreign profits are in theory subject to a 35% U.S. corporate tax. In fact, no U.S. tax is due on these foreign profits unless and until they are brought back to the U.S. Given these tax choices, it is no surprise that almost $2 trillion in foreign profits of U.S. corporations are kept abroad and not repatriated to the U.S.

Treasury receives very little tax revenues from foreign profits of U.S. corporations , although the U.S. statutory rate of 35% on corporate profits is one of the highest in the world. Like almost every other country, the U.S. provides a credit against U.S. taxes for any foreign taxes paid on foreign income. For example, if a U.S. corporation pays taxes of 33% of its Japanese profits, it can bring these profits back to the U.S. by paying only a 2% tax rate (the U.S. rate of 35% minus a tax credit of 33%). On the other hand, if a U.S. corporation pays an 18% tax rate on its Spanish profits, it will rarely be willing to pay another 17% U.S. tax ( the U.S. rate of 35% minus a tax credit of 18% ) to bring these Spanish profits back to the U.S.

Moreover, foreign profits kept abroad may not be used by a U.S. multinational to pay U.S. dividends to its shareholders. As a result, many U.S. multinationals with loads of cash from foreign operations must borrow to pay U.S. dividends to their shareholders (or repurchase outstanding shares). That’s why we see the surrealist picture of Microsoft, with $80 billion in cash and short-term investments, taking out loans to pay U.S. dividends. Although the interest rate on such loans for dividends has been very low since 2008, these loans will become more expensive in the future as interest rates rise.

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Thus, the current U.S. tax system is a major barrier to the growth of the U.S. economy. The system discourages U.S. multinationals from deploying their foreign profits to construct plants or build research facilities in the U.S. These U.S. companies cannot even use foreign profits to acquire U.S. firms or patents –without paying a stiff U.S. tax on the repatriation of profits used to make such acquisitions. Rather, the system encourages U.S. multinationals to devote most of their foreign profits to building facilities abroad and buying foreign firms.

So Congress should change these perverse corporate incentives as quickly as possible. The problem is urgent because foreign profits of U.S. corporations are rising rapidly. Many U.S. multinationals already earn a majority of their profits in foreign jurisdictions. These foreign profits will expand even faster if they are mainly used to build foreign facilities and buy foreign firms. This is a downward spiral that will systematically deplete an important source of corporate capital for U.S. economic growth.

Some Congressional staff would disagree that this problem is urgent. They assume that, if the U.S. tax laws are not amended soon, U.S. multinationals will be forced to repatriate most of their foreign profits to the U.S. at a 35% tax rate. Under this assumption, if Congress reduced the U.S. tax rate on foreign profits to encourage their repatriation, that legislation would be a big revenue loser. Thus, this assumption is a major barrier to sensible tax reform; in this budget environment, any tax legislation must be at least revenue neutral.

However, there is little evidence supporting the assumption that U.S. multinationals will pay a 35% tax to bring back most of their foreign profits to the U.S. In fact, U.S. multinationals repatriate their foreign profits mainly when they are in financial distress, or when they can apply foreign tax credits to reduce their effective U.S. tax rate on their foreign profits to less than 10%. Instead of paying a 35% U.S. tax, U.S. multinationals will keep their foreign profits abroad. Under this realistic view, if Congress persuaded U.S. multinationals to repatriate more of their foreign profits by offering a lower U.S. tax rate, that legislation would be a big revenue gainer.

Indeed, based on a realistic revenue projection, lowering the U.S. tax rate on foreign earnings may be the best way to lower the general corporate rate below 35%. If such a lower rate induced U.S. multinationals to bring back a lot more of their foreign profits to the U.S., that would not only promote U.S. economic growth but could also finance a rate reduction on domestic corporate profits – without a bitter political fight on repealing existing tax preferences.

What is a sensible and realistic proposal to reform the current U.S. system for taxing the foreign profits of U.S. corporations? The second part of this paper will suggest an approach based on the concept of a global competitiveness tax, and then will explain why this approach is superior to other tax proposals currently before Congress.